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Creating a Private Foundation to Meet Charitable Goals

A private foundation set up by an individual provides
the opportunity to shift income to an entity that will
be taxed at a minimal rate, achieve tax savings, and
direct charitable giving, yet the individual maintains
control over the assets used to fulfill charitable
purposes. For some individuals, maintaining control over
assets set aside for charitable commitments is
important, while others would prefer to make an outright
gift. If an individual has strong charitable
convictions, a planned gift-giving program could include
setting up a private foundation.

Private
foundations are an excellent way to involve family in
long-range charitable giving, investing and controlling
funds available for charitable distribution, and meeting
charitable commitments regardless of personal financial
fluctuations. However, because of the restrictions on
activities of a private foundation, the costs associated
with operating one, and the limitations imposed on the
deductibility of contributions, the practitioner should
carefully analyze a taxpayer’s goals to determine if a
private foundation is appropriate.

Requirements
and Characteristics of a Private Foundation

A
private foundation is any organization described in Sec.
501(c)(3), other than a public charity, a publicly
supported organization, or a supporting organization.
The most common type is a nonoperating foundation. In
simplest form, a nonoperating foundation is a separate
legal entity that holds funds as an endowment and uses
the income to support other charitable activities and
organizations. By contrast, an operating foundation (for
example, a museum) uses its funds for its own operation,
including the purchase and maintenance of assets.

The foundation’s assets can be used for religious,
charitable, literary, scientific, and educational
purposes, preventing cruelty to children or animals, or
fostering amateur sports competition (other than
providing athletic facilities or equipment) (Secs.
170(c)(2)(B) and 4942(g)(1)). A private foundation can
also contribute to government entities described in Sec.
170(c)(1) (Regs. Sec. 53.4942(a)-3(a)(2)).

The
benefits of establishing and funding a private
foundation include the following:

Control: Once donors make gifts to
public charities, they typically have no control over
how their donations are used. However, with a private
foundation, the donor is often also a foundation manager
and so is able to control how the foundation invests its
assets and ultimately disburses them for charitable
purposes.

Legacy: Donors often name their
foundations after themselves or their families. Although
a large gift to a public charity can provide lasting
name recognition to the donor (such as when a university
names a building after a substantial donor), it is often
easier (and perhaps less expensive) to perpetuate the
family name using a foundation.

Family ties: Donors often view a
foundation as a way to bind a family together with a
common interest. Often, a private foundation’s board
includes several members from a donor’s family, such as
the spouse, children, or grandchildren. Many donors also
see the foundation as a way to pass on to younger family
members their ideas about philanthropy.

Narrowly defined causes: Donors can
use a private foundation to advance or support
charitable causes that public charities in their area do
not serve or are not interested in.

Long-term charitable giving goals: A
private foundation may provide the opportunity to meet
long-term charitable giving goals by using the
essentially tax-free buildup of assets.

Current tax deductions for funding:
The income, gift, or estate tax charitable
contribution deduction is available upon funding the
foundation, even though the foundation may not make the
charitable distribution until some time in the
future.

Relief from solicitation requests: A
private foundation can be used to relieve the donor from
the burden of having to personally respond when
solicited for charitable contributions. Instead, the
donor can refer requests to the foundation.

Disadvantages of a Private Foundation

However, there are some disadvantages to be aware of
when determining whether a private foundation is
appropriate:

Foundations are costly: The donor
will incur costs to organize and operate a private
foundation. Usually, professional fees are incurred to
draft the organizational document, ensure that all state
filing requirements are met, file the application for
exemption from federal income tax (Form 1023,
Application for Recognition of Exemption Under Section
501(c)(3) of the Internal Revenue Code), maintain
accounting records, and annually file Form 990-PF,
Return of Private Foundation or Section 4947(a)(1)
Nonexempt Charitable Trust Treated as a Private
Foundation. There may also be state reporting
requirements.

Income tax deduction is more limited:
Individuals may deduct cash gifts to
public charities up to 50% of their AGI and property
gifts up to 30% of AGI (unless the donor elects to
deduct the cost basis rather than the FMV of the
property) (Secs. 170(b)(1)(A) and (C)(iii)). With a
private nonoperating foundation, however, the deduction
for cash gifts is generally limited to 30% of AGI, and
property gifts are normally deductible only up to 20% of
AGI (Secs. 170(b)(1)(B) and (D)).

Penalty (excise) taxes can be levied:
Most private foundations must pay an
annual excise tax of 2% of their net investment income.
(Some foundations qualify for a 1% rate—see Sec.
4940(e).) In addition, private foundations (and in some
cases their managers or boards) are potentially subject
to excise taxes because of self-dealing, a failure to
distribute income, excess business holdings, political
expenditures, or inappropriate expenditures or
investments (see Secs. 4941–4945 and 4955). These excise
tax rules are complex and potentially very costly.

Public inspection: A private
foundation’s annual tax returns (Form 990-PF) and
supporting documents, including names and addresses of
contributors, must be available for public inspection.
This can be an issue for donors concerned about their
privacy.

Administrative complexity: Many
individuals do not fully comprehend the administrative
time required to compile the information needed to
comply with the various rules for reporting foundation
activities. Likewise, individuals may not fully
understand the complexity of the restrictions placed
upon disqualified persons.

Identifying Clients
That May Benefit from a Private Foundation

Generally, an individual must have fairly high wealth
and a desire to make substantial charitable
contributions to derive benefits that exceed the cost of
establishing a private foundation.

Often, a
private foundation is established when the donor’s
taxable income is unusually high. The donor shelters
that income from tax with funds that are not actually
disbursed to charity for some time. In addition, an
individual may want to secure a charitable contribution
deduction in a high-income year but cannot decide on the
charitable recipient. A private foundation can be formed
and funded (generating a current charitable contribution
deduction), although distribution to the ultimate
recipient is deferred.

Establishing a private
foundation may be appropriate for an individual who has
made charitable commitments for an extended period. The
individual can fund the foundation currently, take a
charitable contribution deduction in a high-income year,
and make future charitable gifts from the foundation.
This strategy works well if the donor funds the
foundation while he or she is in a higher tax bracket
than the years the charitable donations are actually
made (e.g., a retiring executive). Not only does the
donor secure a current tax deduction, he or she also
obtains nearly tax-free asset growth to fulfill future
charitable commitments.

An individual planning to
bequeath a large amount to charity may prefer leaving
the assets to a private foundation rather than gifting
them outright to a public charity. During his or her
lifetime, the donor establishes the foundation, defines
the charitable purposes in the foundation’s
organizational documents, and can also appoint the
foundation officers. Establishing a private foundation
gives some assurance that the funds will be distributed,
over time, to charitable causes that the donor wishes to
support.

An individual with an interest in a cause
not well supported by public charities can form a
private foundation. For example, the foundation could
grant scholarships to a certain class of individuals
(e.g., children living in an orphanage) or provide
research grants for a specific topic.

Finally,
some wealthy donors use private foundations to bind the
family together by supporting a common interest. The
foundation’s board may contain several family members
who share a sense of working together for a common goal.
The foundation can also employ members of the donor’s
family. However, the salary should be reasonable based
on the duties performed to avoid any risk of being an
act of self-dealing.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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